A Few Basis Points Won’t Win Over Investors: Vanguard’s Kinniry

By Brendan Conway

The competition in exchange-traded fund land certainly is heating up. Market watchers have been chastised for calling it a price war, which, in truth, I guess it isn’t — not if prices are already cut for the big, generic ETFs.

To borrow from Clausewitz, it’s war by other means. When expense ratios are close, other qualities become the deciding factor — for instance, bid-ask spreads, trading volume, or index choice.

I spoke with Fran Kinniry, a principal in Vanguard’s investment strategy group, by phone this afternoon on the subject. In a not-so-veiled critique of BlackRock’s (BLK) new core ETFs, Kinniry said it’s tough to convince investors to leave what they’re using today over a matter of a few basis points.

“This is for any product — when there’s not a significant price difference, the other costs become the primary driver,” Kinniry said. “You need to enter with a very, very unique product,” Kinniry added. “[Or if] there are well-traded alternatives, the price discount had better be pretty darn severe.”

Building big enough trading volume, and the tight bid-ask spreads that accompany it, can be a chicken-and-egg issue unless there’s a very clear incentive to switch, Kinniry said. “Advisors and [many] institutions couldn’t touch [a fund with] trading volume like this,” he said, referring to what’s been seen in the first few days of trading in BlackRock’s new ETFs. “Forget these new funds. … [A]ll new ETFs that have not had a substantial discount have had a hard time gaining volume,” he said.

Volume in the iShares “core” funds has actually been pretty good, given that they’re new ETFs. They’re still nowhere near what the established products have and may not be for some time. The iShares Core MSCI Emerging Markets ETF (IEMG) traded less than 9,800 shares today, according to FactSet Research Systems. On Wednesday, the figure was nearly 150,000. Vanguard Emerging Markets (VWO), the biggest EM ETF by assets, had 11.5 million. The figure for the iShares MSCI Emerging Markets Index Fund (EEM), often preferred by institutions, was 41 million.

Kinniry said he’s seen clients impressed with the big expense-ratio difference between Vanguard Emerging Markets (VWO), at 0.20%, and the iShares MSCI Emerging Markets Index Fund (EEM), at 0.67%. That doesn’t make as much sense when compared to the reaction to smaller percentage differences that matter more when the portfolio weight is bigger.

Kinniry said some clients are less impressed with the 22-basis point difference between the developed-world Vanguard MSCI EAFE ETF (VEA) and the iShares MSCI EAFE (EFA), at 0.34%.

But measured in raw dollars, it’s usually better, Kinniry notes. That’s because the typical investor buys more developed-world exposure than emerging markets. Let’s say you split a $100,000 portfolio between 75% wealthy-country stock markets and 25% emerging-markets. In dollars, you’d save $220 per year in the 75% of the pie that is the developed world, using VEA versus EFA. Though the percentage difference is bigger in the smaller emerging-markets slice, the savings would amount to a smaller $117.50.

If the difference amounts to two basis points under Vanguard Emerging Markets’ (VWO) 0.20% — that’s what IEMG charges — then other factors are likely to win out.

But the difference turns out to be more than that. Or, it will be soon. That’s throwing in the upcoming Vanguard index changes, in which the company will shift several popular funds to FTSE Group indexes, away from MSCI Inc. (MSCI). Investors will need to weigh index construction, investment mandates and more.

“To be blunt, investors need to make a choice which index vendor and asset manager they’re going to go with,” Kinniry says.

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.